Secured Debts in Chapter 7 Bankruptcy: An Overview

Secured debts are treated differently in Chapter 7 bankruptcy than other kinds of debts.

Most people have a loan that’s secured by property, such as a mortgage or a car loan. These debts—called secured debts—can be tricky in Chapter 7 bankruptcy. Although the secured debt itself can be wiped out (discharged)—and often is—the creditor will still have a right to take the property back if you fail to pay (default on) the payments.

If you want to keep property securing a loan—such as a house or a car—your options in Chapter 7 bankruptcy will depend on whether you’re current on your payments. (You can find more information in Secured Debt & Property in Chapter 7 Bankruptcy.)

What Is a Secured Debt?

Almost without exception, if you’re making payments on an item of property, you’ve agreed that the property will serve as collateral for repayment of the debt. If you default on your payments, the creditor (or lender) can repossess the property, sell it, and obtain a court judgment against you (a deficiency judgment) for the difference between the amount you owe and the auction price (however, some states have laws against deficiency judgments).

A secured debt has two parts:

Personal liability. You have personal liability for a secured debt just as you would for any other debt. You’re obligated to pay the debt to the creditor. Chapter 7 bankruptcy wipes out this personal liability if it’s the type of debt that can be discharged in bankruptcy. Once your personal liability is eliminated, the creditor cannot sue you to collect the debt.

Security interest. The second part of a secured debt is the creditor’s legal claim (lien or security interest) on the property that serves as collateral for the debt. The lien gives the creditor the right to repossess the property or force its sale if you don’t pay the debt. Liens aren’t affected by the bankruptcy discharge. In other words, if you don’t remain current on payments, you can lose the property, even if the debt itself is discharged. In some cases, however, you can ask the bankruptcy court to remove the lien as part of your bankruptcy case. (Learn more in What Happens to Liens in Chapter 7 Bankruptcy?)

Options in Chapter 7 Bankruptcy

Here’s what can be done with property securing a debt in Chapter 7 bankruptcy (assuming that you meet all requirements):

Let the property go back to the bank. You can walk away free and clear by surrendering the property and discharging the underlying debt. This option is available to all filers.

Keep the property and continue making payments. You can continue under the same contract terms as long as you’re current on your payments and you can protect your equity with an exemption. This process is known as reaffirming the debt.

Pay the fair market value for the property. You can keep the property by redeeming it (paying what it’s worth in one lump sum payment) as long as you can protect your equity with an exemption and the property meets other requirements (for instance, you can’t redeem real estate). (Learn more in Redeeming Secured Property in Chapter 7 Bankruptcy.)

Can You Exempt (Keep) Your Property Equity?

You’re able to protect some property when you file for bankruptcy, but there are limits. Whether you’ll be able to keep a particular asset will also depend on the exemptions allowed by your state. If you can’t protect all of the equity, the bankruptcy trustee assigned to the case will sell the asset for the benefit of your creditors.

Example. Suppose that you owe $3,000 on a car worth $6,000 (leaving you with $3,000 of equity) and that your state’s vehicle exemption will allow you to protect $1,000. You likely wouldn’t be able to keep the car. Instead, the trustee would sell it, pay your secured creditor the $3,000 you still owe, give you your $1,000 exemption in cash, and distribute the remaining $2,000 (less costs of sale and the trustee’s commission) to creditors.

Even so, debtors frequently owe more on a secured loan than the property securing the debt is worth—which by definition means they have no equity in the property. If you don’t have equity in the property, or if it’s fully protected by an exemption, the trustee won’t be able to sell it. You could keep the asset by either redeeming or reaffirming the loan.

Chapter 13 Can Help With Late Payments

Chapter 7 bankruptcy doesn’t have a mechanism to help you catch up on payment arrearages. Unless you can make arrangements with the lender outside of bankruptcy, you’ll likely lose the property after your case ends, or sooner if the creditor successfully asks the court to lift the stay to allow for foreclosure or repossession. (To learn more about the automatic stay, see How Bankruptcy Stops Your Creditors: The Automatic Stay.)

If you’re behind and you want to keep the property, Chapter 13 bankruptcy is probably the better choice. You can make up the missed payments in your plan as long as you also make the regular payments called for under your original agreement. Also, in Chapter 13, you might be able to reduce the total amount of your payments to the property’s actual value. (Find out more in Chapter 13 Bankruptcy.)